A. O. Smith_ Put together To Purchase This Quick-Rising Dividend Aristocrat (NYSE_AOS)

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Introduction

When folks consider dividend aristocrats, they most of the time consider previous, mature firms with respectable yields and low development charges. That may be a cheap assumption, as mature firms, most of the time, include larger dividend yields and slower development. Nevertheless, there are some exceptions. The Milwaukee, Wisconsin, based mostly A. O. Smith Company (NYSE:AOS) has raised its dividend for 30 consecutive years. Nevertheless, as a substitute of slowing down, the corporate maintains a double-digit long-term dividend development charge, speedy free money move development, a wholesome steadiness sheet, and a enterprise mannequin that may greater than seemingly present outperforming capital positive aspects the second the housing market rebounds.

On this article, we’ll focus on all of that as I will make an funding case for two.0%-yielding AOS shares.

So, bear with me!

What’s AOS?

A. O. Smith is among the oldest firms I’ve ever mentioned on Searching for Alpha. The corporate’s historical past goes again to 1874 when it was based by Charles Jeremiah Smith as C.J. Smith and Sons. Again then, the corporate was a child carriage and bicycle components producer.

Within the Nineteen Sixties, it opened a industrial water heater and boiler plant in Stratford, Ontario. By 1969, the corporate had produced its 10-millionth residential water heater. This enterprise is now the core of the corporate.

On a aspect notice, I simply skipped nearly 100 years of the corporate’s historical past. For those who’re within the particulars, the corporate’s Wikipedia web page is really fascinating because it exhibits how some firms remodel and adapt to new applied sciences and innovation.

Quick ahead, we’re now coping with an organization that employs near 14,000 folks with worldwide operations. The corporate has one working phase, which is water heaters, boilers, tanks, and water remedy. AOS sells these in its two areas: North America (71% of 2021 gross sales) and the remainder of the world.

A. O. Smith Company

The remainder of the world phase primarily covers China, Europe, and India. These segments primarily manufacture and market of their respective areas of the world.

In China, the corporate has been working for greater than 25 years. The Chinese language water heater market is predominantly comprised of electrical wall-hung, gasoline tankless, combi-boiler, warmth pump, and photo voltaic water heaters. The corporate believes it is among the main suppliers of water heaters and reverse osmosis water remedy merchandise to the residential market in China in greenback phrases.

In america, the corporate affords a variety of water heaters, boilers, and water remedy merchandise. In 2016, AOS purchased Aquasana, which added water remedy publicity to the OAS portfolio. Since then, the corporate has purchased a number of different firms to broaden its operations on this key business centered on water high quality.

A Quick-Rising Dividend Aristocrat

A dividend aristocrat is an organization that has hiked its dividend for no less than 25 consecutive years. A. O. Smith is in that class with greater than 30 uninterrupted dividend hikes.

There are a number of explanation why dividend aristocrats are so particular and useful for long-term wealth era.

Based on S&P World (SPGI):

“Dividends play an essential function in producing fairness whole return. Since 1926, dividends have contributed roughly 32% of whole return for the S&P 500, whereas capital appreciations have contributed 68%. Subsequently, sustainable dividend revenue and capital appreciation potential are essential components for whole return expectations.

Throughout the entire time horizons measured, the S&P 500 Dividend Aristocrats exhibited larger returns with decrease volatility in contrast with the S&P 500, leading to larger Sharpe ratios.”

This evaluation is sensible, as I’ve usually made the case that the power to pay a dividend is a stamp of approval. Surviving in a aggressive enterprise atmosphere is hard. Letting buyers profit by common money funds within the type of dividends is not simple.

Nuveen

Dividend development firms exhibit a particular means to thrive. The market rewards that with long-term outperformance and subdued volatility as buyers want to promote lower-quality shares throughout bear markets.

With that mentioned, AOS is an outperformer. Going again to 1986, the inventory has returned 13.4%. This beats the S&P 500 by roughly 300 foundation factors per yr. Whereas AOS outperforms the market fairly persistently, it isn’t a low-volatility inventory. That’s solely based mostly on its cyclical enterprise mannequin, which relies on housing demand and associated monetary indicators. Therefore, the inventory is underperforming the market on a 3/5-year foundation as the information under exhibits. This underperformance began in early 2022 when the market peaked. Since then, the inventory has misplaced roughly a 3rd of its market cap. However extra on that later.

Portfolio Visualizer

With that in thoughts, AOS shares presently pay a dividend of $0.30 per share per quarter. That is $1.20 per yr, which interprets to a dividend yield of two.0%.

Whereas 2.0% is not a excessive yield,it is larger than the “common” dividend aristocrat and dividend development inventory yields.

ProShares S&P 500 Dividend Aristocrats ETF (NOBL): 1.9% yield

Vanguard Dividend Appreciation Index Fund (VIG): 1.8% yield

Furthermore, the corporate’s Searching for Alpha dividend scorecard exhibits numerous inexperienced. The corporate scores very excessive on dividend consistency (it is a dividend aristocrat) and dividend development and considerably excessive on security and yield.

Searching for Alpha

The “A” dividend development rating could be defined by a 10-year common annual compounding dividend development charge of 20.3%. The commercial sector median is 7.9%. On a five-year foundation, these numbers drop to fifteen.3% and seven.5%, respectively.

Knowledge by YCharts

With that mentioned, the corporate’s dividend development is not simply excessive, it is also very sustainable.

Because the overview under exhibits, the corporate’s capital priorities are:

Natural development by investments in its enterprise segments and capabilities.

Acquisitions so as to add new capabilities.

Dividends are anticipated to develop step by step after the corporate has taken care of natural and bought development.

Extra money can be utilized on share repurchases.

A. O. Smith Company (Writer Annotation)

Whereas it’s inconceivable to include future acquisitions into monetary expectations, we are able to show capital expenditures (natural development) and the corporate’s debt place. What you are under is the corporate’s free money move, CapEx, and internet debt. Free money move is money an organization can spend on dividends, buybacks, and debt discount after it has taken care of funding wants (CapEx necessities). As the corporate’s CapEx necessities have remained very steady all through the previous few cycles, the corporate can flip larger working development into excessive free money move.

Between 2012 and 2024E, the annual compounding income development charge is 5.8%. Normalized internet revenue is rising by 11.0% CAGR. Free money move is rising by 17.7% CAGR. Because of this the corporate is more and more environment friendly in terms of turning larger development into even larger money era. That’s nice information for all events concerned.

It additionally helps the corporate’s intention to keep up robust, double-digit dividend development.

Furthermore, the corporate has destructive internet debt, which implies AOS has extra cash than gross debt on its steadiness sheet. As analysts will not be incorporating buybacks into their fashions, internet debt is predicted to fall into deeper destructive territory within the years forward.

That mentioned, if we assume that the corporate can do $509 million in FCF in 2023, it could suggest a 5.4% FCF yield utilizing its $9.5 billion market cap. This not solely covers its 2.0% dividend yield but in addition leaves numerous room for buybacks. Based on the corporate:

The power of our steadiness sheet permits us to keep up our robust monitor report of delivering returns to shareholders. This has been finished by each our dividend that we’ve elevated for 30 consecutive years in addition to share repurchases which have totaled $650 million for the reason that starting of 2021.

Over the previous ten years, the corporate has repurchased 17% of its shares excellent. This helped to show 230% internet revenue development into 288% earnings per share development.

Knowledge by YCharts

With that mentioned, let’s dive into the valuation.

Valuation

AOS shares are up 7% this yr, however down 26.5% over the previous 12 months.

FINVIZ

Weak point began in early 2022 when buyers began to cost in a a lot weaker housing market. The chart under compares the AOS inventory worth to constructing permits.

TradingView (AOS, Constructing Permits)

Because the free money move chart on this article confirmed, the ultimate outcomes for 2022 are anticipated to point out a weaker yr. In its North America phase in 3Q22 (the newest quarter), the corporate generated 1% decrease gross sales as volumes triggered a $100 million headwind. Adjusted working earnings have been down as inflation triggered extra headwinds, pressuring margins.

A. O. Smith Company

In the remainder of the world, gross sales have been down 13% because of decrease Chinese language volumes, which greater than offset 16% development in India. Working earnings fell from $27 million to $22 million because of the aforementioned weak point in Chinese language orders.

The Chinese language reopening is nice information for the corporate as it would enhance volumes within the quarters forward.

On a full-year foundation, the corporate expects no less than 5% income development.

We undertaking income development for 2022 of 5% to 7%, which is decrease than our outlook in July because of softer-than-expected demand in residential water heating. Our gross sales assumptions embrace, after roughly 8% development in every of the final two years, which is effectively above the historic common development charge, we estimate U.S. residential water heater business unit volumes shall be down roughly 12% to 13% on final yr as prospects rightsize their inventories and business demand normalizes.

This yr, the corporate is predicted to generate $740 million in EBITDA, which suggests 2.7% EBITDA development after 1.5% anticipated development in 2022. The corporate is buying and selling at 12.3x 2023E EBITDA based mostly onits $9.1 billion enterprise worth (market cap plus internet money).

This valuation may be very truthful and effectively under the longer-term median near 13x NTM EBITDA.

Given the financial circumstances, I imagine that AOS is a superb purchase near $50. At that time, I might purchase in intervals, that means including step by step over time. If the housing market continues to weaken, buyers will seemingly have the ability to common down. If the inventory market all of the sudden takes off, buyers have a foot within the door.

Takeaway

A. O. Smith is an amazing long-term compounder. The corporate is working in a mature enterprise, however able to excessive development due to its portfolio of superior heaters, boilers, and water remedy merchandise. Due to this, the corporate can shield its standing as a dividend aristocrat with double-digit annual dividend hikes. These are backed by excessive and fast-rising free money move, a wholesome steadiness sheet, and administration’s willingness to let shareholders profit.

The one downside is that AOS suffered from provide chain points and Chinese language lockdowns. Now, the corporate can be being pressured by weakening housing demand, which is able to seemingly be a subject of dialogue within the subsequent earnings name.

Whereas I imagine that AOS will stay rangebound because of macroeconomic challenges, I’ve little doubt that the inventory will outperform the market on a long-term foundation and get away as quickly as demand bottoms. I anticipate that to occur within the second half of this yr.

(Dis)agree? Let me know within the feedback!